What if Your State Goes Bankrupt?

Under existing law, a state cannot go bankrupt. That's not because the action is forbidden. Not the U.S. Constitution nor any other piece of paper says a state cannot. The bankruptcy code simply does not address the possibility.

Now lawyers, politicians and other ingenious folk are looking for a way around that problem -- a fact that should come as no surprise, given the perilous financial health of California, Illinois and other states encumbered with crushing debts.

The 50 states have spent collectively, in the past two years, half a trillion more dollars than they took in as taxes. Their pension funds, by some estimates, are underfunded by another trillion.

Like Titanic victims struggling in the water, they are desperately grabbing any orange crate that floats by, trying anything to stay afloat.

Arizona has sold off its state capitol. The investment group that now owns the Supreme Court building and the chambers of the house and senate is graciously leasing those buildings back to the people.

California, facing a $19 billion shortfall, must now spend more on pensions for its public employees than it spends on the University of California system. U.C., to avoid having to make deeper cuts than it has already made, hiked tuitions 32 percent in November 2008, igniting student protests. The Golden State's credit rating has sunk almost to junk status.

What a tonic, then, if these states could toss off their obligations, as one might a heavy coat. By declaring bankruptcy, states could start life anew and go skipping down the street.

Orange County, Calif., did it. Vallejo, Calif., did it. Harrisburg, Pa., is said to be thinking about doing it. They used Chapter 9 of the bankruptcy code, which applies to municipalities.

Law professor David Skeel of the University of Pennsylvania said he sees no reason why Chapter 9 could not be tweaked to apply to states. Doing so would be easy, he said: "You'd just have to change Chapter 9's definition of permitted entrants. Basically, you'd change the entrance requirements."

That change, of course, would require legislative action -- a process "always uncertain." An alternative would be to use Chapter 8, "which isn't currently taken," and use it to create something entirely fresh and new, exclusively for states, he said.

If and when states do grope their way to bankruptcy, the consequences would be most dramatic for state pensioners and for holders of state bonds.

Once a state had entered bankruptcy, Skeel, said there could be sales of assets -- something akin to a corporate liquidation sale. Creditors, including bond holders and unions, would be compelled to make concessions. With court approval, a state could rewrite its union contracts. Vallejo, Calif., has done just that.

Any attempt by California to use bankruptcy law to claw back pension benefits, he says, would be "legally and morally wrong. State retires have dedicated entire careers to state service. They have earned their pensions."